Andy Pitt: Is income-only or total return investment best for your charity?

When did you last review your investment mandate? Are you taking unappreciated risks in following an income-only approach? Andy Pitt assesses what to consider when answering these questions.

Understanding the best available investment option is important for any charity. A common question investment managers hear is whether charities should take an income-only or a total return approach. But why has interest in this subject increased?

Two major changes have been seen in recent years. Firstly, the investment choices available have increased greatly over the last two decades. While much of this modern investment technology offers lower income yields than traditional instruments, it can provide greater capital appreciation and better diversification and risk management.

Second interest rates and bond yield have collapsed in the last few years, making it increasingly difficult to generate reasonable levels of income. To fulfil traditional income-only mandates, investment managers may be consciously or otherwise placing the capital at greater risk and with it the charity’s future activities.

Advantages of an income-only approach

Ease of identification

Any income arising from an investment portfolio is easily identifiable compared to capital appreciation, so it is easy to ensure that only income is spent and to assess whether you are achieving your income objective.

Reliability of income

A suitably diversified income-only strategy tends to produce a fairly stable level of income. Even in a recession, equity dividends tend not to decline as much as corporate earnings, as directors try to maintain dividends to uphold shareholder confidence.

Income is a good measure of value

Income represents one of the more reliable measures of value. If there is no income (eg as with a commodity such as gold), it is more difficult to value an investment.

Disadvantages of an income-only approach

Current income levels are low

Today’s environment makes it harder than ever to achieve decent levels of income. One only has to look at the Bank of England’s base rate, which at the time of writing is 0.75 per cent, to appreciate the scale of the problem.

An income-only approach may reduce your investment opportunity set

Investing for income-only introduces a bias against stocks or asset classes that pay little or no income. But does it make sense to ignore smaller, fast-growing companies that need to reinvest all of their profits to fund their growth?

Similarly, certain alternative investments such as private equity, absolute return funds, structured products and commodities can also be attractive. Should one exclude them and have a less well diversified portfolio, just because those asset classes don’t produce dividends in the traditional sense?

Income is only part of the return

An income-only approach doesn’t utilise any capital gains that might arise and, perhaps more importantly, ignores capital losses. If you strip out dividends, equities normally produce real capital returns over long periods of time, so why ignore this element? Equally, spending the income from a portfolio of conventional bonds is a sure way to end up with no portfolio over the long term.

Advantages of a total return approach

Given the greater flexibility offered by total return, such an approach can be incorporate almost everything that an income-only strategy can, but without the disadvantages.

It doesn’t matter that income levels are low

The fact that current income levels are low isn’t such a big issue for a total return investor

A total return approach maximises your investment choices

A total return investor has the broadest universe of investments and asset classes to choose from. This offers benefits from both a risk and a return perspective.

Higher withdrawals

A total return strategy may enable you to make a slightly higher withdrawal than if you pursue an income-only strategy, because equities normally produce real capital returns over the long term.

Disadvantages of a total return approach

A total return approach is slightly more complicated than an income-only approach, in so far as identification of return goes. This disadvantage is, however, relatively easy to overcome.

Which approach should you choose?

The reliability of income-only, or the ability to better diversify risk with total return?

There are pros and cons to each, and for some charities, a blend of both could be the best option. Charities can consider the many benefits that an income-only approach can offer, but we would advise that they do so within a total return framework.

The ability to diversify risk is greater for a charity adopting a total return approach, which is a benefit that should certainly be considered given the challenging investment environment that is likely to persist for the foreseeable future.

Andy Pitt is head of charities, London at Rathbones

Civil Society Media would like to thank Rathbones for its support with this article.